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  1. 1. Insurance and Risk Finance 640 An Introduction George D. Krempley September 22, 2004
  2. 2. Introduction <ul><li>“The acknowledgement that risk exists in all investments is the first step in financial wisdom.” </li></ul><ul><ul><ul><ul><ul><li>Grace Kim, Associate Director </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Executive Education, University of Chicago, </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Graduate School of Business </li></ul></ul></ul></ul></ul><ul><li>“Knowledge is cumulative; wisdom is not.” </li></ul><ul><ul><ul><ul><ul><li>Anonymous </li></ul></ul></ul></ul></ul>
  3. 3. Introduction (cont.) <ul><li>“ The market has been somewhat complacent on high oil prices….” </li></ul><ul><li>As prices failed to decline but instead rose in the month of July, the market acted negatively. </li></ul><ul><li>Higher oil prices generally are a drag on corporate profits and can lead to higher levels of inflation. </li></ul><ul><li>This is a risk that the market is beginning to take more seriously.” </li></ul><ul><ul><ul><ul><ul><li>Chuck Bath </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Managing Director – Equities </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Diamond Hill </li></ul></ul></ul></ul></ul>
  4. 4. Risk Analysis: How good is it? <ul><li>Alabama Shore Homes before Hurricane Ivan </li></ul><ul><li>Ben Krempley and his bicycle parked in the middle of the street </li></ul><ul><li>Driving behavior considering mortality statistics </li></ul>
  5. 5. My Point of View <ul><li>Human beings have great difficulty identifying and managing risk. </li></ul><ul><li>The judgments we make about risk are erratic and error-prone. </li></ul><ul><li>Our attempt to live with risk is a continuous exercise in decision-making under uncertainty. </li></ul>
  6. 6. My Point of View (cont.) <ul><li>Because we don’t recognize risk, we suffer unnecessary costs. </li></ul><ul><ul><li>Money </li></ul></ul><ul><ul><li>Heartache </li></ul></ul><ul><ul><li>Frustration </li></ul></ul><ul><li>To counteract the error-prone nature of our judgment, we need a method. </li></ul><ul><li>Learning this method does not require great genius. </li></ul>
  7. 7. “Order and method, Hastings…order and method” <ul><li>What is required is a language to assist us with observation and measurement. </li></ul><ul><li>Could we see and treat risk without definitions and categories? </li></ul><ul><li>What is the purpose of language? </li></ul><ul><ul><li>Include or Exclude? </li></ul></ul>
  8. 8. Method Defined <ul><li>A method is a defined approach or sequence of steps to produce a desired outcome. </li></ul>
  9. 9. Key Tasks for Today <ul><li>Define Risk </li></ul><ul><li>Categorize Risk into Types </li></ul><ul><li>Understand the Cost of Risk </li></ul><ul><ul><li>Components of the Cost of Risk </li></ul></ul><ul><ul><li>Cost Tradeoffs </li></ul></ul>
  10. 10. Key Tasks (cont.) <ul><li>Compare Pure to Speculative risk. </li></ul><ul><li>Define the Concept of Loss Exposure </li></ul><ul><li>Apply Loss Exposure to Analyze A Case </li></ul>
  11. 11. Key Tasks (cont.) <ul><li>Define Risk Management and its Primary Objective </li></ul><ul><li>Look at the relationship of Risk Aversion to Insurance Demand </li></ul><ul><li>Revisit Diminishing Marginal Utility </li></ul>
  12. 12. Harrington and Niehaus Argue There are two meanings of Risk: <ul><li>A situation is riskier than another when: </li></ul><ul><ul><ul><li>There is greater expected loss, </li></ul></ul></ul><ul><ul><ul><ul><ul><li>Or… </li></ul></ul></ul></ul></ul><ul><ul><ul><li>There is greater variance in outcomes </li></ul></ul></ul>
  13. 13. Risk is: Greater expected loss <ul><li>Examples: </li></ul><ul><ul><li>California has more earthquake risk than North Carolina, but </li></ul></ul><ul><ul><li>North Carolina has more hurricane risk than California </li></ul></ul><ul><ul><li>Young male drivers are riskier than middle-aged drivers </li></ul></ul><ul><ul><li>Skateboarders are likelier to have accidental injuries than bookworms </li></ul></ul>
  14. 14. IIHS Statistics 3 years experience
  15. 15. Limitations of the first definition of risk <ul><li>If we could predict the future with total certainty, most of our decisions would be trivial. </li></ul><ul><li>We would simply choose the course of action that would yield the highest expected value. </li></ul>
  16. 16. Expected Value Rule <ul><li>Expected value rule holds that: </li></ul><ul><ul><li>In an uncertain situation, human beings will select the alternative with the highest expected value. </li></ul></ul><ul><li>Does it work? </li></ul><ul><ul><li>Does it account for human behavior? </li></ul></ul><ul><ul><li>Can we use it to predict behavior? </li></ul></ul>
  17. 17. Expected Value <ul><li>EV =  P X </li></ul><ul><li>Where: </li></ul><ul><li>EV = the expected value of the outcome </li></ul><ul><li>P = the probability of outcome, X </li></ul><ul><li>X = the outcome in money value </li></ul><ul><li> = “the sum of” </li></ul>j i i i
  18. 18. Expected Value Rule: Prediction <ul><li>Everyone will always and everywhere invest in the stock market. </li></ul><ul><li>Why? “In an uncertain situation, human beings will select the alternative with the highest expected value.” </li></ul><ul><li>Does this hold? </li></ul>
  19. 19. S& P 500 Index Returns
  20. 20. Investment Performance 1926-1998
  21. 21. St. Petersburg Paradox <ul><li>18th century Swiss mathematician and physicist, Daniel Bernoulli </li></ul><ul><li>Showed how the expected value rule regularly breaks down. </li></ul>
  22. 22. Consider the following <ul><li>One player flips a fair coin </li></ul><ul><li>If coin lands heads, the player will pay the other player $2.00. </li></ul><ul><li>If the coin lands tails, it is tossed again. </li></ul><ul><li>If the second toss heads, the first player plays the second player ($2.00) and the game is over. </li></ul>2
  23. 23. Consider…(cont.) <ul><li>The game is continued until the first head appears. </li></ul><ul><li>The first player pays the second player: ($2.00) i </li></ul><ul><ul><li>Where i equals the number of tosses required to get the first head. </li></ul></ul><ul><li>How much will the second player being willing to pay to enter the game? </li></ul>
  24. 24. Consider… <ul><li>Seldom is anyone willing to pay more than $10.00. </li></ul><ul><li>But, the game has an infinite value </li></ul><ul><li> P i i X i i = (2)( ½) + (2) ² ( ½)² + (2) ³ ( ½)³ </li></ul><ul><ul><ul><ul><li>= 1 + 1+ 1 = Infinity </li></ul></ul></ul></ul>
  25. 25. The Question <ul><li>Why will people only pay a few dollars to enter a game that has an infinite value? </li></ul>
  26. 26. Subjective Risk <ul><li>Subjective risk: the mental state of uncertainty of the individual </li></ul><ul><li>Subjective risk is </li></ul><ul><ul><li>Personal </li></ul></ul><ul><ul><li>Not easily measured. </li></ul></ul>
  27. 27. Second Definition of Risk <ul><li>The probable variation of the actual outcome from the expected value. </li></ul><ul><li>Exposure to risk is created: </li></ul><ul><ul><li>Whenever circumstances give rise to an outcome that cannot be predicted with certainty </li></ul></ul>
  28. 28. Implications of Second Definition of Risk <ul><li>Risks can be statistically measured by some measure of dispersion. </li></ul><ul><li>Because risk is measurable, people can agree on seeing the “same” thing. </li></ul><ul><ul><li>In this sense, it is “objective”. We can say it “exists”. </li></ul></ul><ul><li>Risk as variation from expected outcome is: </li></ul><ul><ul><li>Measurable </li></ul></ul><ul><ul><li>Statistical </li></ul></ul><ul><ul><li>Verifiable </li></ul></ul>
  29. 29. Risk - A Key Distinction <ul><li>If risk is defined as variability, risk does not imply that outcomes are adverse or negative. </li></ul><ul><li>Rather, risk implies that outcomes are not known in advance. </li></ul><ul><li>“Not knowing” the future creates risk. </li></ul>
  30. 30. Common risk measures <ul><li>Standard deviation </li></ul><ul><li>Variance </li></ul><ul><li>Beta </li></ul><ul><li>Each summarizes the pattern and extent of the variability of outcomes. </li></ul>
  31. 31. Loss Exposure <ul><li>Set of circumstances that presents the possibility of loss, whether or not a loss actually occurs. </li></ul><ul><li>Implies the existence of something that may decline in value </li></ul><ul><li>The object and the circumstances can be objectively verified </li></ul>
  32. 32. Elements of a Loss Exposure <ul><li>The item subject to loss </li></ul><ul><li>The perils, or forces that may cause the loss </li></ul><ul><li>The potential financial impact of the loss </li></ul>
  33. 33. Financial Examples: Greater Variability Around The Expected Outcome <ul><li>The stock market has greater variability than the bond market </li></ul><ul><li>Within stock market, a bio-tech stock is riskier than a utility stock </li></ul>
  34. 34. Key Point: Risk Is Costly <ul><li>Regardless of which definition, greater risk imposes costs (reduces value) </li></ul><ul><li>Identical properties subject to damage </li></ul><ul><ul><li>Greater expected property loss lowers value of property, all else equal </li></ul></ul><ul><ul><li>Greater uncertainty about property loss often lowers value of property, all else equal </li></ul></ul>
  35. 35. Direct Losses often Cause Indirect Losses <ul><ul><li>Example: What are the direct and indirect losses if a manufacturing plant experiences a major fire? </li></ul></ul>
  36. 36. Diversifiable and Non-diversifiable Risk <ul><li>A risk is diversifiable if it is possible to reduce a risk through pooling or risk sharing agreements. </li></ul><ul><li>Risk is non-diversifiable if pooling agreements are ineffective in reducing risk for the participants in the pool. </li></ul>
  37. 37. Systematic and Non-systematic Risk <ul><li>Risk that cannot be eliminated by diversification is called systematic risk. </li></ul><ul><li>Systematic risk is risk that belongs to the group; also known as market risk. </li></ul><ul><li>Risk that can be eliminated by diversification is called non-systematic risk. </li></ul><ul><li>Non-systematic risk is also known as unique risk. </li></ul>
  38. 38. Pure and Speculative Risk <ul><li>A pure risk is where there are only the possibilities of loss or no loss. </li></ul><ul><li>A speculative risk is a risk where either profit or loss is possible. </li></ul>
  39. 39. Speculative and Pure Risk Examples <ul><li>Speculative Risk </li></ul><ul><li>Starting a business </li></ul><ul><li>Introducing a new product/entering a new market </li></ul><ul><li>Investing in a security </li></ul><ul><li>Change in government regulation </li></ul><ul><li>Social change </li></ul><ul><li>Pure Risk </li></ul><ul><li>Property destruction </li></ul><ul><li>Injury to employees on the job </li></ul><ul><li>Illness or death </li></ul><ul><li>Injury to customers and third parties </li></ul><ul><li>Damage to the property of others </li></ul>
  40. 40. Major Types of Business Risk
  41. 41. Pure Risk versus Other Types of Risk <ul><li>Pure risk usually involves large potential losses relative to the expected loss </li></ul><ul><ul><ul><li>Pure risk involves events that are firm-specific </li></ul></ul></ul><ul><ul><ul><li>Price risk affects many firms </li></ul></ul></ul><ul><ul><ul><li>Pure risk is managed by insurance </li></ul></ul></ul><ul><ul><ul><li>Price risk is managed by derivatives </li></ul></ul></ul><ul><ul><ul><li>Pure risk involves wealth losses to society </li></ul></ul></ul><ul><ul><ul><li>Price risk often involves wealth redistributions in society </li></ul></ul></ul><ul><li>Nevertheless, use the same framework for management of pure risk and price risk </li></ul>
  42. 42. Pure Risks Categories <ul><li>Personal Risks </li></ul><ul><li>Property Risks </li></ul><ul><li>Net Income Risks </li></ul><ul><li>Liability Risks </li></ul>
  43. 43. Personal Risks <ul><li>Risk of premature death </li></ul><ul><li>Risk of poor health </li></ul><ul><li>Risk of disability </li></ul><ul><li>Risk of unemployment </li></ul><ul><li>Risk of insufficient income or savings during retirement (living too long) </li></ul>
  44. 44. Major Types of Personal Risks
  45. 45. Property Risks <ul><li>Direct loss to real or personal property from: </li></ul><ul><ul><li>Physical damage, destruction or theft of the property </li></ul></ul><ul><li>Real property </li></ul><ul><ul><li>Unimproved land </li></ul></ul><ul><ul><li>Buildings </li></ul></ul><ul><ul><li>Other structures </li></ul></ul>
  46. 46. Property (cont.) <ul><li>Personal Property - Tangible </li></ul><ul><ul><li>Machinery </li></ul></ul><ul><ul><li>Inventory </li></ul></ul><ul><ul><li>Furniture, equipment and supplies </li></ul></ul><ul><ul><li>Mobile property </li></ul></ul><ul><ul><li>Accounts receivable, valuable papers and documents </li></ul></ul><ul><ul><li>Money and securities </li></ul></ul><ul><ul><li>Data processing hardware, software and media </li></ul></ul>
  47. 47. Property (cont.) <ul><li>Personal Property - Intangible </li></ul><ul><ul><li>Goodwill </li></ul></ul><ul><ul><li>Copyrights </li></ul></ul><ul><ul><li>Trademarks and trade names </li></ul></ul><ul><ul><li>Patents </li></ul></ul><ul><ul><li>Leases and leasehold interests </li></ul></ul><ul><ul><li>Licenses </li></ul></ul><ul><ul><li>Trade secrets </li></ul></ul>
  48. 48. Net Income Risks <ul><li>Indirect loss as a result of direct loss. Also known as consequential loss. </li></ul><ul><li>Examples: </li></ul><ul><ul><li>Loss of sales or rents </li></ul></ul><ul><ul><li>Loss of profits </li></ul></ul><ul><ul><li>Extra expenses </li></ul></ul>
  49. 49. Liability Risks <ul><li>Liability arises from an act or omission: </li></ul><ul><ul><li>That breaches another’s legal right and </li></ul></ul><ul><ul><li>Causes harm or injury to the other person or the person’s property </li></ul></ul><ul><li>Three types of legal wrongs: </li></ul><ul><ul><li>Crime </li></ul></ul><ul><ul><li>Breach of contract </li></ul></ul><ul><ul><li>Tort </li></ul></ul>
  50. 50. Risk Management Argument <ul><li>If people do not “live” by EV alone, what is the implication for decision-makers? </li></ul><ul><li>Risk is an important decision factor. </li></ul><ul><li>It needs to be: </li></ul><ul><ul><li>Identified </li></ul></ul><ul><ul><li>Measured </li></ul></ul><ul><ul><li>Explicitly factored into a rational decision-making method </li></ul></ul>
  51. 51. Risk Management <ul><li>Broadly defined, business risk management is a method for making decisions </li></ul><ul><li>Regarding how to treat exposures to loss in business value from any source. </li></ul>
  52. 52. The Risk Management Process <ul><li>Identification of risks </li></ul><ul><li>Evaluation of frequency and severity of losses </li></ul><ul><li>Choosing risk management methods </li></ul><ul><li>Implementation of the chosen methods </li></ul><ul><li>Monitoring the performance and suitability of the methods. </li></ul>
  53. 53. Risk Management Questions <ul><ul><li>What is the problem? (risk identification) </li></ul></ul><ul><ul><li>2. What is the magnitude of the problem? (measurement) </li></ul></ul><ul><ul><li>3. How should the problem be handled? (decision) </li></ul></ul>
  54. 54. Risk Identification Tools <ul><li>Surveys and questionnaires </li></ul><ul><li>Loss Histories </li></ul><ul><li>Financial Statements and other Accounting Records </li></ul><ul><li>Flowcharts </li></ul><ul><li>Reviewing other records including contracts </li></ul><ul><li>Personal inspection </li></ul><ul><li>Expertise within and outside organization </li></ul>
  55. 55. Pure Risk Management Measures <ul><li>Frequency = Probability of X </li></ul><ul><li>Severity = Outcome of X </li></ul><ul><li>Expected Loss = Expected Value </li></ul><ul><li>Frequency  Severity = Expected Loss </li></ul>
  56. 56. Risk Management Vs. Insurance <ul><li>Risk management is a decision process; insurance is a financial product </li></ul><ul><li>Risk management focuses on identifying and measuring risks to select the most appropriate technique. </li></ul><ul><li>Insurance is only one of several options to treat pure loss exposures. </li></ul>
  57. 57. Major Risk Management Methods
  58. 58. Risk Management Techniques <ul><li>Avoidance </li></ul><ul><li>Retention </li></ul><ul><li>Loss control and reduction </li></ul><ul><li>Non-insurance transfer </li></ul><ul><li>Insurance </li></ul>
  59. 59. Retention <ul><li>Current Expensing of Losses </li></ul><ul><li>Unfunded Reserve </li></ul><ul><li>Funded Reserve </li></ul><ul><li>Borrowing </li></ul><ul><li>Captive Insurance </li></ul>
  60. 60. Risk Transfer <ul><li>Non-insurance risk transfer </li></ul><ul><ul><li>Contractual </li></ul></ul><ul><ul><li>Organizational </li></ul></ul><ul><li>Insurance </li></ul><ul><li>Securitization of risk </li></ul><ul><ul><li>Catastrophe bonds </li></ul></ul><ul><li>Hedging (speculative risk only) </li></ul>
  61. 61. Risk Management Matrix
  62. 62. Two Definitions of Insurance <ul><li>Reducing risk by combining a group of risks so that the accidental losses to which the group is subjected become predictable within narrow limits. </li></ul><ul><li>Pooling of fortuitous losses by transfer to an insurer, who agrees to indemnify insureds for such losses and render services connected with the risk. </li></ul>
  63. 63. Risk Management Objective <ul><li>What criteria should be used for for making choices about how much risk management to undertake? </li></ul><ul><li>According to Harrington and Niehaus, the appropriate criteria: </li></ul><ul><ul><li> Minimize Cost of Risk </li></ul></ul>
  64. 64. Costs of Risk Vs. Cost of Risk Management <ul><li>Risk imposes costs on businesses and individuals </li></ul><ul><li>Risk Management (e.g., loss control and insurance) also is costly </li></ul><ul><li> Tradeoffs must be made </li></ul>
  65. 65. Components of the Cost of Risk
  66. 66. Tradeoffs in the Cost of Risk <ul><ul><li>Decreasing one component of the cost of risk usually is associated with an increase in another component </li></ul></ul><ul><ul><li>Examples: </li></ul></ul><ul><ul><ul><li>Decreasing expected direct losses (worker injury costs) by increasing loss control costs (increased workplace safety) </li></ul></ul></ul><ul><ul><ul><li>Decreasing expected indirect losses (bankruptcy costs) by increasing loss financing costs (insurance costs ) </li></ul></ul></ul><ul><ul><ul><li>Decreasing cost of residual uncertainty by increasing loss financing costs (insurance costs) </li></ul></ul></ul>
  67. 67. Cost of Risk Example <ul><ul><li>Firm value in ideal world of no risk = $100,000. </li></ul></ul><ul><ul><li>Issues to be examined: </li></ul></ul><ul><ul><ul><li>What is firm value with risk of worker injuries? </li></ul></ul></ul><ul><ul><ul><li>What is relation between firm value and cost of risk? </li></ul></ul></ul>
  68. 68. Cost of Risk Example <ul><li>Business is faced with one source of risk: </li></ul><ul><li>Probability of worker injury = 1/10 </li></ul><ul><li>Losses from a worker injury: </li></ul><ul><li>medical expenses $10,000 </li></ul><ul><li>lost pay $50,000 </li></ul><ul><li>total $60,000 </li></ul><ul><ul><li>Expected loss = $_________ </li></ul></ul>
  69. 69. Cost of Risk Example <ul><li>Option 1: Do Nothing </li></ul><ul><ul><li>Cost of risk: </li></ul></ul><ul><ul><ul><li>Expected loss = $________ </li></ul></ul></ul><ul><ul><ul><li>Cost of residual uncertainty = $4,000 (assumed) </li></ul></ul></ul><ul><ul><ul><li>Cost of loss control = $0 </li></ul></ul></ul><ul><ul><ul><li>Cost of loss financing = $0 </li></ul></ul></ul><ul><ul><ul><li>Cost of internal risk reduction = $0 </li></ul></ul></ul><ul><ul><li>Total cost of risk = $__________ </li></ul></ul><ul><ul><li>Firm value = $100,000 - $________ = $_________ </li></ul></ul>
  70. 70. Cost of Risk Example <ul><li>Option 2: Loss control </li></ul><ul><ul><li>Spend $2,000 to reduce probability of loss to 1/20 </li></ul></ul><ul><ul><li>Cost of risk: </li></ul></ul><ul><ul><ul><li>Expected loss = $_________ </li></ul></ul></ul><ul><ul><ul><li>Cost of residual uncertainty = $3,000 (assumed) </li></ul></ul></ul><ul><ul><ul><li>Cost of loss control = $2,000 </li></ul></ul></ul><ul><ul><ul><li>Cost of loss financing = $0 </li></ul></ul></ul><ul><ul><ul><li>Cost of internal risk reduction = $0 </li></ul></ul></ul><ul><ul><li>Total cost of risk = $_________ </li></ul></ul><ul><ul><li>Firm value = $100,000 - $________ = $_________ </li></ul></ul>
  71. 71. Cost of Risk Example <ul><li>Option 3: Additional Loss control </li></ul><ul><ul><li>Spend an additional $2,000 to reduce probability of loss to 1/40 </li></ul></ul><ul><ul><li>Cost of risk: </li></ul></ul><ul><ul><ul><li>Expected loss = $________ </li></ul></ul></ul><ul><ul><ul><li>Cost of residual uncertainty = $2,700 (assumed) </li></ul></ul></ul><ul><ul><ul><li>Cost of loss control = $4,000 </li></ul></ul></ul><ul><ul><ul><li>Cost of loss financing = $0 </li></ul></ul></ul><ul><ul><ul><li>Cost of internal risk reduction = $0 </li></ul></ul></ul><ul><ul><li>Total cost of risk = $__________ </li></ul></ul><ul><ul><li>Firm value = $100,000 - $_________= $___________ </li></ul></ul>
  72. 72. Cost of Risk Example <ul><ul><li>Option 4: No loss control, but full insurance </li></ul></ul><ul><ul><li>Premium = $7,500 </li></ul></ul><ul><ul><ul><ul><li>Loading = premium - expected loss = $7,500 - $6,000 = $1,500 </li></ul></ul></ul></ul><ul><ul><li>Cost of risk: </li></ul></ul><ul><ul><ul><li>Expected loss = $6,000 </li></ul></ul></ul><ul><ul><ul><li>Cost of residual uncertainty = $0 </li></ul></ul></ul><ul><ul><ul><li>Cost of loss control = $0 </li></ul></ul></ul><ul><ul><ul><li>Cost of loss financing = $1,500 </li></ul></ul></ul><ul><ul><ul><li>Cost of internal risk reduction = $0 </li></ul></ul></ul><ul><ul><li>Total cost of risk = $7,500 </li></ul></ul><ul><ul><li>Firm value = $100,000 -$7,500 = $92,500 </li></ul></ul>
  73. 73. Cost of Risk Example <ul><ul><li>Key points from example: </li></ul></ul><ul><ul><ul><li>Do NOT minimize risk, Minimize cost of risk </li></ul></ul></ul><ul><ul><ul><li>There are cost tradeoffs: </li></ul></ul></ul><ul><ul><ul><ul><li>Increase insurance coverage ==> </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Increase loading paid </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Decrease residual uncertainty </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><li>Additional loss control ==> </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Decrease expected losses </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Increase loss control costs </li></ul></ul></ul></ul></ul>
  74. 74. Determinants of Value <ul><li>Firm Value depends on </li></ul><ul><ul><ul><li>Magnitude of expected net cash flows </li></ul></ul></ul><ul><ul><ul><li>Timing of expected net cash flows </li></ul></ul></ul><ul><ul><ul><li>Risk of expected net cash flows </li></ul></ul></ul><ul><ul><li>Net cash flows = cash inflows – cash outflows </li></ul></ul>
  75. 75. Maximizing Value by Minimizing Cost of Risk <ul><li>Define: </li></ul><ul><ul><li>Cost of risk = Value without risk – Value with risk </li></ul></ul><ul><li>Rearrange: </li></ul><ul><ul><li>Value with risk = Value without risk – Cost of risk </li></ul></ul><ul><li>Implication: </li></ul><ul><ul><li>Maximize Value  Minimize Cost of Risk </li></ul></ul>Hypothetical construct
  76. 76. Agency Costs <ul><li>Owners have a clear incentive to maximize the value of their own businesses. </li></ul><ul><li>Managers may have a different set of motivations, including being excessively cautious. </li></ul><ul><li>As a result, managers may take actions which fail to maximize shareholder wealth. </li></ul><ul><li>For example, they may purchase unnecessary insurance. </li></ul><ul><li>The costs associated with these actions are called “Agency Costs”. </li></ul>
  77. 77. Do Managers Maximize Shareholder Value? <ul><ul><li>In practice, there are several factors that motivate managers to maximize shareholder value </li></ul></ul><ul><ul><ul><li>Management compensation contracts (e.g., bonuses) </li></ul></ul></ul><ul><ul><ul><li>Market for corporate control (e.g., hostile takeovers) </li></ul></ul></ul><ul><ul><ul><li>Product market competition </li></ul></ul></ul><ul><ul><ul><li>Monitoring by shareholders with large stakes </li></ul></ul></ul><ul><ul><ul><li>Legal duty of managers </li></ul></ul></ul>
  78. 78. Individual RM and the Cost of Risk <ul><ul><li>Cost of risk concept applies to individual RM </li></ul></ul><ul><ul><li>An individual’s cost of residual uncertainty depends on the person’s degree of risk aversion </li></ul></ul><ul><ul><li>Risk aversion  </li></ul></ul><ul><ul><ul><li>Pay extra to reduce risk (buy insurance even though premium exceeds expected claim costs) </li></ul></ul></ul><ul><ul><ul><li>Require higher expected returns to take on more risk (demand higher expected returns on riskier stocks) </li></ul></ul></ul>
  79. 79. Risk Management & Societal Welfare <ul><ul><li>Minimizing the cost of risk is also an appropriate objective for society, because doing so generally results in an efficient level of risk for society </li></ul></ul><ul><ul><li>Efficiency ==> risky activities are pursued until the marginal costs exceed the marginal benefits </li></ul></ul><ul><ul><li>Implication: public policies should consider the cost tradeoffs </li></ul></ul><ul><ul><ul><li>Example: greater safety regulation  lower expected losses, but higher loss control costs </li></ul></ul></ul>
  80. 80. Conflict between Private & Societal Objectives <ul><ul><li>Issue: </li></ul></ul><ul><ul><ul><li>Will individuals and businesses acting to minimize their own cost of risk result in the minimization of society’s cost of risk? </li></ul></ul></ul><ul><ul><li>Observe: </li></ul></ul><ul><ul><ul><li>For a business to maximize value (minimize its own cost of risk), the business must consider the effect of its decisions on other parties (even in the absence of regulation and legal liability) </li></ul></ul></ul><ul><ul><ul><li>Why – b/c decisions affect the terms at which other parties contract with the firm </li></ul></ul></ul><ul><ul><ul><li>Example: riskier workplace  higher wages </li></ul></ul></ul>
  81. 81. <ul><ul><li>What if business cost of risk < societal cost of risk? </li></ul></ul><ul><ul><ul><li>Example: workers are uninformed about injury risk </li></ul></ul></ul><ul><ul><li>Then, a business might engage in excessively risky behavior (they may not consider the effects of risk on other claimants) </li></ul></ul><ul><ul><li>Thus, there is a potential role for regulation and legal liability. </li></ul></ul><ul><ul><li>Regulation and legal liability should induce managers to make decisions that minimize society’s cost of risk </li></ul></ul>Conflict:Private & Societal Objectives
  82. 82. Review of Economic Theory <ul><li>Economists believe that most individuals are risk-averse. </li></ul><ul><ul><li>A risk averse person would prefer to hold the asset with less variable returns. </li></ul></ul><ul><li>Most individuals display risk-averse behavior when they purchase insurance. </li></ul><ul><li>They pay a premium to be compensated for possible events that would destroy their wealth. </li></ul><ul><ul><li>Often the premium exceeds the expected value of the risk </li></ul></ul>
  83. 83. Law of Diminishing Marginal Utility <ul><li>If I am poor, an addition of $1000 to my wealth will make a considerable impact on my level of welfare. </li></ul><ul><li>If I am rich, the extra $1000 will still increase my satisfaction, but only marginally. </li></ul>
  84. 84. Marginal Utility (cont.) <ul><li>In other words: </li></ul><ul><ul><li>Each additional dollar of wealth has less utility than the preceding dollar: </li></ul></ul><ul><li>Captured in conventional phrases: </li></ul><ul><ul><li>“He/she has nothing to lose.” </li></ul></ul><ul><ul><li>“A bird in the hand is worth two in the bush.” </li></ul></ul>
  85. 85. Expected Utility Rule <ul><li>Decision rule that substitutes utility for expected value. </li></ul><ul><li>Utility is a measurement of satisfaction with some economic “good”, such as wealth. </li></ul><ul><li>Developed by John von Neumann and Oskar Morgenstern in 1944. </li></ul>
  86. 86. Insurance and the Expected Utility Rule <ul><li>An insurance policy sacrifices certain wealth to avoid the possibility of loss of wealth. </li></ul><ul><li>A speculative investment involves the sacrifice of certain wealth to acquire the possibility of an increase in wealth. </li></ul>
  87. 87. Benefit of Insurance <ul><li>Certainty is gained at the cost of a reduction in wealth. </li></ul><ul><li>The certainty is “experienced” because the risk is transferred to the insurance company. </li></ul><ul><li>The insured benefits from insurance whether or not there was a loss. </li></ul><ul><li>Therefore, the primary benefit of insurance is certainty, not the payment of a claim. </li></ul>
  88. 88. Demand for Insurance by Individuals <ul><li>Why do individuals take actions to reduce risk? </li></ul><ul><ul><li>Simple answer: they are risk averse </li></ul></ul><ul><ul><li>Risk aversion ==> prefer certain outcome to an uncertain outcome with the same expected value </li></ul></ul>
  89. 89. The Effects of Insurance on Wealth <ul><li>Begin by examining the effects of insurance on a person’s wealth </li></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>Wealth without insurance = $80,000 or $100,000 with equal probability </li></ul></ul></ul><ul><ul><ul><ul><li>i.e., there is a 0.5 chance of a $20,000 loss for a person with $100,000 </li></ul></ul></ul></ul>
  90. 90. The Effects of Insurance on Wealth <ul><ul><li>Wealth with no insurance </li></ul></ul><ul><ul><li>Wealth with $10,000 of coverage for a premium of $5,000? </li></ul></ul><ul><ul><li>Wealth with $20,000 of coverage for a premium of $10,000 </li></ul></ul>Wealth $80,000 $100,000 Wealth $80,000 $100,000 $80,000 $100,000 Wealth
  91. 91. The Effects of Insurance on Wealth <ul><ul><li>Important Point: </li></ul></ul><ul><ul><ul><li>Insurance reduces wealth if a loss does not occur </li></ul></ul></ul><ul><ul><ul><li>Insurance increases wealth if a loss does occur </li></ul></ul></ul><ul><ul><li>Useful perspective when thinking about insurance purchases: </li></ul></ul><ul><ul><ul><li>do I want to give up some wealth when a loss does not occur so that I will receive additional wealth when a loss does occur? </li></ul></ul></ul>
  92. 92. Risk Aversion <ul><ul><li>A risk averse person prefers a certain amount of wealth to a risky situation with the same expected wealth </li></ul></ul><ul><ul><ul><li>Example: </li></ul></ul></ul><ul><ul><ul><ul><li>Would you accept a 50-50 chance of winning $1,000 or losing $1,000? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The gamble does not change a person’s expected wealth, but it makes the person’s wealth uncertain </li></ul></ul></ul></ul><ul><ul><ul><ul><li>A risk-averse person therefore would choose not to accept the gamble </li></ul></ul></ul></ul>
  93. 93. Risk Aversion <ul><li>A risk averse person would require compensation (called a risk premium) before accepting the gamble in this example </li></ul><ul><ul><ul><li>change the odds (e.g., 60% chance of winning) </li></ul></ul></ul><ul><ul><ul><li>change the payoffs (e.g., win $1,400, lose $1,000) </li></ul></ul></ul><ul><ul><ul><li>The additional expected wealth ($200) needed to induce a risk averse person to accept the gamble is the premium required to compensate the person for the risk </li></ul></ul></ul><ul><li>A risk neutral person would not require a risk premium to accept this gamble; a risk neutral person only cares about expected wealth </li></ul>
  94. 94. Risk Aversion <ul><ul><li>A risk averse person would be willing to pay more than the expected loss to reduce risk </li></ul></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>2% chance of losing $10,000 </li></ul></ul></ul><ul><ul><ul><li>Expected loss = $200 </li></ul></ul></ul><ul><ul><ul><li>A risk averse person would pay more than $200 to eliminate the risk </li></ul></ul></ul>
  95. 95. Risk Aversion <ul><ul><li>Most people behave as if they are risk averse </li></ul></ul><ul><ul><ul><li>Require compensation for engaging in risky activities </li></ul></ul></ul><ul><ul><ul><ul><li>they require additional expected return to invest in riskier securities </li></ul></ul></ul></ul><ul><ul><ul><li>Are willing to pay to avoid risky activities </li></ul></ul></ul><ul><ul><ul><ul><li>they will pay positive loadings for insurance </li></ul></ul></ul></ul>
  96. 96. Factors Affecting the Demand for Insurance <ul><ul><li>Premium Loadings </li></ul></ul><ul><ul><ul><li>As loading increases, quantity of insurance purchased generally falls </li></ul></ul></ul><ul><ul><li>Income and Wealth </li></ul></ul><ul><ul><ul><li>More wealth is usually associated with more assets to lose and therefore more insurance coverage </li></ul></ul></ul><ul><ul><ul><li>Limited resources may prevent people from purchasing insurance </li></ul></ul></ul><ul><ul><ul><li>Degree of risk aversion may decline as wealth increases </li></ul></ul></ul><ul><ul><ul><li>Limited liability may cause poor people to buy less liability insurance coverage </li></ul></ul></ul>
  97. 97. Factors Affecting the Demand for Insurance <ul><ul><li>Information </li></ul></ul><ul><ul><ul><li>Individual’s perception of loading </li></ul></ul></ul><ul><ul><ul><li>Underestimate the true risk ==> buy less insurance </li></ul></ul></ul><ul><ul><ul><li>Overestimate the true risk ==> buy more insurance </li></ul></ul></ul><ul><ul><li>Other Sources of Indemnity </li></ul></ul><ul><ul><ul><li>If others (e.g., society or family) will pay uninsured loss, buy less coverage </li></ul></ul></ul>
  98. 98. Factors Affecting the Demand for Insurance <ul><ul><li>Non-monetary Losses </li></ul></ul><ul><ul><ul><li>Examples: </li></ul></ul></ul><ul><ul><ul><ul><li>pain and suffering </li></ul></ul></ul></ul><ul><ul><ul><ul><li>loss of heirloom </li></ul></ul></ul></ul><ul><ul><ul><ul><li>loss of consortium </li></ul></ul></ul></ul><ul><ul><ul><li>Demand for insurance against non-monetary losses differs from demand for insurance against monetary losses </li></ul></ul></ul>
  99. 99. Factors Affecting the Demand for Insurance <ul><ul><li>Why do people buy insurance against monetary losses? </li></ul></ul><ul><ul><ul><li>because insurance gives them money when it means the most to them, i.e., when they have less of it (following a loss) </li></ul></ul></ul><ul><ul><ul><li>This logic does not necessarily apply to non-monetary losses </li></ul></ul></ul>
  100. 100. Factors Affecting the Demand for Insurance <ul><li>Money does not necessarily mean more to people following a non-monetary loss </li></ul><ul><li>Indeed, the opposite could hold </li></ul><ul><ul><ul><ul><li>Example: loss of child </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Many people would prefer to have more money when the child is alive than when the child is dead </li></ul></ul></ul></ul><ul><li>Thus, many people would not demand insurance against non-monetary losses even if there were no premium loading </li></ul>
  101. 101. Business Risk Management <ul><ul><li>Main Points: </li></ul></ul><ul><ul><ul><li>Shareholder diversification reduces risk </li></ul></ul></ul><ul><ul><ul><li>Shareholder diversification potentially substitutes for corporate risk management </li></ul></ul></ul><ul><ul><ul><ul><li>Why should corporations reduce risk when shareholders are diversified? </li></ul></ul></ul></ul>
  102. 102. Why Do Corporations Manage Risk? <ul><ul><li>Some businesses are closely held </li></ul></ul><ul><ul><ul><li>owners are not diversified </li></ul></ul></ul><ul><ul><li>Insurers provide services at lower costs than they can be purchased elsewhere </li></ul></ul><ul><ul><ul><li>loss control </li></ul></ul></ul><ul><ul><ul><li>claims processing </li></ul></ul></ul>
  103. 103. Why Do Corporations Manage Risk? <ul><ul><li>Insurance might be the lowest cost method of financing losses </li></ul></ul><ul><ul><li>Alternative methods of paying losses </li></ul></ul><ul><ul><ul><li>insurance </li></ul></ul></ul><ul><ul><ul><li>internal funds </li></ul></ul></ul><ul><ul><ul><li>raise new funds </li></ul></ul></ul><ul><ul><ul><li>For firms without sufficient internal funds, insurance premium loading can be lower than the expected cost of raising new funds following a loss </li></ul></ul></ul>
  104. 104. Why Do Corporations Manage Risk? <ul><ul><li>Insurance might reduce expected financing costs for new investment projects </li></ul></ul><ul><ul><li>Paying losses from internal funds increases the likelihood that new funds will have to be raised to finance new investment projects </li></ul></ul><ul><ul><li>Cost of raising new funds </li></ul></ul><ul><ul><ul><li>lowers value of new projects </li></ul></ul></ul><ul><ul><ul><li>may pass up some good projects </li></ul></ul></ul><ul><ul><li>Purchase insurance to avoid these scenarios </li></ul></ul>
  105. 105. Why Do Corporations Manage Risk? <ul><ul><li>Reduce the likelihood of financial distress </li></ul></ul><ul><ul><ul><li>Bankruptcy is costly to shareholders (must pay accountants, lawyers, etc) </li></ul></ul></ul><ul><ul><ul><li>Reducing risk reduces likelihood of incurring these direct bankruptcy costs </li></ul></ul></ul>
  106. 106. Why Do Corporations Manage Risk? <ul><ul><li>Reduce the likelihood of financial distress </li></ul></ul><ul><ul><ul><li>Bankruptcy is costly to other claimants (e.g., employees, lenders, suppliers, customers) </li></ul></ul></ul><ul><ul><ul><li>These claimants require compensation for this risk (e.g., higher wages, higher lending rates) </li></ul></ul></ul><ul><ul><ul><li>Shareholders can reduce costs by lowering likelihood of bankruptcy </li></ul></ul></ul>
  107. 107. Why Do Corporations Manage Risk? <ul><ul><li>Reducing risk lowers expected tax payments for several reasons: </li></ul></ul><ul><ul><ul><li>discussed in greater detail in Chapter 21 </li></ul></ul></ul>
  108. 108. Two Definitions of Insurance <ul><li>Reducing risk by </li></ul><ul><ul><li>combining a group of risks </li></ul></ul><ul><ul><li>so that the accidental losses to which the group is subjected </li></ul></ul><ul><ul><li>become predictable within narrow limits. </li></ul></ul><ul><li>Pooling of fortuitous losses </li></ul><ul><ul><li>by transfer to an insurer, </li></ul></ul><ul><ul><li>who agrees to indemnify insureds for such losses, and </li></ul></ul><ul><ul><li>render services connected with the risk. </li></ul></ul>
  109. 109. Basic Characteristics of Insurance <ul><li>Pooling of losses </li></ul><ul><li>Payment of fortuitous losses </li></ul><ul><li>Risk transfer </li></ul><ul><li>Indemnification </li></ul>
  110. 110. Pooling <ul><li>Spreading losses incurred by the few over the entire group so that the average loss is substituted for actual loss. </li></ul><ul><li>“I have been loss-free for 5 years, how can they possibly justify raising my premium?” </li></ul><ul><li>Example of 10 Boats on the Yangtze. </li></ul>
  111. 111. How Big Should the Pool Be? <ul><li>The greater the number of exposures, the more closely will the actual result approach the expected result. </li></ul><ul><li>This is known as the Law of Large Numbers. </li></ul><ul><li>It is derived from the Central Limit Theorem. </li></ul>
  112. 112. Central Limit Theorem <ul><li>In random samples of n observations, the distribution of the sample means will be a normal distribution. </li></ul><ul><li>The mean of the sample distribution will equal the mean of the population distribution. </li></ul>
  113. 113. Central Limit Theorem (cont.) <ul><li>The standard error of the sample mean will be equal to the standard error of the population divided by the square root of n. </li></ul><ul><li>The standard error of the sampling distribution can be reduced simply by increasing the sample size. </li></ul>
  114. 114. Insurance and Law of Large Numbers <ul><li>Insurance companies expect losses to occur. </li></ul><ul><li>The major concern is the deviation between actual losses and expected losses. </li></ul><ul><li>By insuring large numbers, insurance companies reduce their objective risk. </li></ul><ul><li>“The whole is less than the sum of its parts.” </li></ul>
  115. 115. Requirements of an Insurable Risk <ul><li>Large number of exposure units </li></ul><ul><ul><li>to predict the average loss within a narrow range </li></ul></ul><ul><li>Accidental and unintentional loss </li></ul><ul><ul><li>to assure randomness </li></ul></ul><ul><ul><li>to control moral hazard </li></ul></ul><ul><li>Determinable and measurable loss </li></ul><ul><ul><li>to facilitate loss adjustment </li></ul></ul>
  116. 116. Insurable Risk (cont.) <ul><li>No catastrophic loss </li></ul><ul><ul><li>So that a large number of losses do not occur at the same time </li></ul></ul><ul><ul><li>To allow pooling to work (spreading of losses of the “few” over the group) </li></ul></ul><ul><li>Calculable probability of loss </li></ul><ul><ul><li>To determine premium needed </li></ul></ul><ul><li>Economically feasible premium </li></ul>
  117. 117. Fire Vs. Cold Weather
  118. 118. Loss Exposure Revisited <ul><li>1. Valued “object” exposed to loss </li></ul><ul><li>2. Peril that could cause loss </li></ul><ul><li>3. Financial consequences of the loss </li></ul>
  119. 119. Peril <ul><li>A peril is defined as a cause of loss. </li></ul><ul><ul><li>If your house burns because of fire, the peril or cause of loss is “fire”. </li></ul></ul><ul><ul><li>If your car is damaged in a collision with another vehicle, the peril is “collision”. </li></ul></ul><ul><li>Insurance policies frequently “package” coverage for various perils </li></ul><ul><ul><li>Known as multi-peril policies </li></ul></ul>
  120. 120. Example of Perils